U.S. Stock Values Have Analysts Worried

Corporate-earnings reports are trickling in, and they aren’t great. J.P. Morgan Chase & Co. was a little better than anticipated; General Electric Co. was as expected; Best Buy Co. was terrible.

Money managers are wondering whether soft earnings will justify more stock gains, given the Dow Jones Industrial Average’s 26.5% rise last year. That helps explain why the Dow is down 118 points to start the year.

Among their biggest questions: Just how expensive are stocks, anyway? Are they overpriced compared with likely earnings gains? What do stocks typically do when they get this pricey? What should investors do?

The answer: By a variety of measures the market is frothy. Some measures, but not all, are close to 2007 and 2008 extremes. They are far from most extremes of 2000, however. So while many investors are turning cautious, few are pulling back wholesale.

His worry is that with the earnings outlook tepid, the risk of a pullback is rising. Many of his clients are risk-averse, so his firm has trimmed stockholdings just in case. That kind of defensive thinking is affecting stock prices.

Investors face two problems: The first is earnings. Of the 52 companies in the S&P 500 index that have reported fourth-quarter results, 52% beat expectations according to S&P Capital IQ, below the average 67% of the past four quarters. Moreover, revenue gains have been weak. Earnings season has just begun and money managers will be watching coming reports closely, including from International Business Machines Corp., Verizon Communications Inc. and McDonald’s Corp. this week.

A second, deeper question is whether future earnings will push stocks much higher, even if they meet analysts’ expectations.

Goldman Sachs investment strategist David Kostin startled investors a week ago by warning that prices are high compared to analysts’ forecasts. The chances are two out of three that the S&P will fall at least 10% sometime this year, before finishing with an overall yearly gain of around 3%, he said.

Mr. Kostin measured stocks many ways; against sales, book value, cash flow, inflation, interest rates and other items. He looked in particular at prices compared with analysts’ earnings forecasts for the next 12 months.

The S&P 500 trades at 16 times forecast earnings, he calculates, well above 13, the average going back to the 1970s. Since 1976, it has hardly ever surpassed 17 times forecast earnings. The main exception came during the stock bubble of the late 1990s and early 2000s.

So he figures it will be hard for price/earnings ratios to rise much. That would limit stock gains to the rate of earnings gains, which have been slowing.

Ned Davis Research in Venice, Fla., has reached similar conclusions. Ned Davis, the firm’s founder, published two reports titled “Overweighted, Over-Believed and Overvalued.” He looked at an array of measures including the percentage of U.S. financial assets held in stocks, margin-debt levels and how much money managers and mutual funds have allocated to stocks.

His conclusion: Investors are overexposed to stocks, but they haven’t gone to bubblelike extremes.

Vincent Deluard, a Ned Davis investment strategist, agrees that the P/E based on forecast earnings is above average. Because forecasts are unreliable, he also tracks earnings for the past 12 months, adjusted for inflation, interest rates and economic growth. All these measures yield a similar conclusion.

“We have a market that is getting a little frothy,” Mr. Deluard says. His team expects a pullback of 10% to 20% in the next six months, but perhaps not right away. Then they expect stocks to rise, maybe for years.

“This is not 2008. This is not 2000. This is more like 1998, where you have some of the signs that you see at tops, but not at extremes,” he says.

Mr. Clemons’s firm, Brown Brothers Harriman, has gradually boosted cash in a typical portfolio to a range of 15% to 20%, far above the normal 3% to 5%. Since stocks have kept rising, clients have endured subpar returns.

A short-term trader would hate that strategy, but Mr. Clemons says his conservative clients welcome it. They miss gains at the top but avoid losses during declines.

“It reflects our client base and the need for the preservation of wealth,” he says.

This view is spreading. When Northern Trust surveyed 100 outside investment managers at the end of last year, 34% called themselves more risk averse, up from 20% in the third quarter. Only 36% said U.S. stocks are undervalued.

But some people disagree. James Paulsen, chief investment strategist at Wells Capital Management, which oversees $340 billion, notes that P/E ratios in the past have moved even higher than they are today before running into real trouble.

As long as inflation stays moderate and the Federal Reserve doesn’t raise interest rates sharply, he says, the P/E ratio on earnings for the past 12 months can hit the 20s from its current level of around 16 or 17.

Yet Mr. Paulsen, too, is worried that 2014 could be a volatile year and that stocks could finish with little or no gain. His concern isn’t valuation; It is that the economy could warm up. Inflation fears could spread, he says, even if actual inflation stays modest. The worries could limit stock gains.

These things are so hard to predict that he and many other money managers are urging clients not to change their holdings or try to time the market.

Still, his concerns show that even people who aren’t worried about valuations are still worrying. Little wonder that stocks are having trouble moving higher.